Having a teenager in the house is an experience – a learning experience. Here is what I learned the other day: when a kid walks into a store and then walks away with some items that he, let’s say, neglected to pay for – there is a term for his activity. And it’s not what you think! The contemporary term is: liberating merchandise.
Would you agree that it sounds way better than stealing or shoplifting? Almost honorable, I’d say. See how a little word substitution can change the entire setup and save you from a lot of trouble? And it will save you, right? I mean, if security stops you at the door, you simply explain them that you were NOT stealing – and they let you go. Just make sure you are not “labeled” a thief – that certainly would be bad for you.
Same with the IRS. As real estate gurus urge you, don’t get “labeled” a dealer. They further explain that being tagged as a dealer could be a financial disaster because of the IRS rules. Their solution? Don’t CALL yourself a dealer, call yourself an investor! See – teenagers already figured this one out, didn’t they?
Well, investment gurus are more sophisticated than teenagers. They know that simply changing a word is not enough. They read the IRS rules and discovered the magic pill: apparently, the IRS is mostly concerned with your intentions. If so, then to determine whether or not you are a dealer, you should determine whether or not you intended to be a dealer.
Yes! Here comes their brilliant and bullet-proof (of course!) trick: write down your statement of intent and make sure that your written intention is to not be a dealer. Bingo! Who could dare to challenge your written statement? Not the dumb IRS agents, that’s for sure!
Just imagine that a stupid security guard catches our creative boy with some unpaid for (oops, I mean liberated) items in his pockets. Thief!!! Not so fast, Mr. Security Conehead! Here is my written statement of intent, in my left back pocket. See? It says, in black and white:
My intention is to pay for everything, every time.
Signed by me and by my Mom. Happy? Now, unlock these handcuffs, and I am going home.
You’ve been guru-ed to
I should not be that sarcastic, I am sorry. After all, one national guru took the time to make a thorough research and discover the ultimate defense: a 1966 Supreme Court case of William Malat. Based on his terrific discovery, any investor can sell literally hundreds of houses without being a dealer – as long as he uses the properly worded statement of intent (conveniently sold by the same guru). And since, as reminded by the guru, Supreme Court is the Law of the Land – move over, the IRS!
Good news: the Supreme Court decisions are, indeed, the Law of the Land. Bad news: the William Malat case absolutely does NOT allow avoidance of dealer status by writing some statement of intent. The circumstances of the case were rather unique, and trying to interpret them as a typical sale of multiple properties is simply irresponsible. Not to mention the minor overlooked detail that the Supreme Court did not even rule on the facts of the case, merely concluding that the lower-level courts used an incorrect legal standard in their earlier ruling against Mr. Malat.
Yes, yes, I know. Me too. I’d love to believe that I can solve all my problems, or at least reduce my taxes, by writing down a few words. Let’s try these:
Dear Santa, please make the IRS go away.
Cheaper than the guru’s “system” – and with the same results.
Dreams and fantasies aside, what is the real story? I’m glad you asked! Let’s take a look.
What is so bad about being a dealer?
Actually, it is true: real estate dealers are penalized by the tax law. Suppose you bought a house for $100,000 and, after a while, sold it for $120,000. Your profit is $20,000 – before the IRS comes in. If you’re an investor, your taxes on this profit can be $3,000 or even less – leaving $17,000 in your pocket. Not if you’re the dreaded dealer! Then, your taxes can be as high as $8,000 – reducing your profit to only $12,000. Compare $12,000 and $17,000 – quite a difference indeed!
There are more problems for the dealers. Let’s say that your buyer could not qualify for a normal loan, and you agreed to owner-finance this house for her. She puts $5,000 down and will be paying the rest of it over 15 years. If you’re an investor, you will pay a small portion of this $5,000 in taxes, and the rest of the tax will be due later, when you receive future payments from the buyer. You pay taxes as you receive income – simple and fair.
Not if you’re a dealer. Dealer will have to pay the entire $8,000 tax right away, even though he hasn’t yet received the money. In fact, this $8,000 tax is more than the $5,000 down payment, and the difference must come out of the dealer’s pocket! Ouch.
And, in case you heard from gurus that smart investors never pay capital gain taxes, here is more bad news: those famous 1031 exchanges are not available to dealers, only to investors.
By now, you and I both agree with the gurus: being a dealer is really bad for your taxes. If you can avoid it, you certainly should. The next logical question is: can you avoid it?
What makes you a dealer?
The gurus are correct on this one, too. It is your intention, also known as business model, also known as exit strategy. In short, how are you planning to make money – by active reselling (dealer) or by passive holding (investor)?
In that guru-abused case of William Malat, the Supreme Court put it this way:
…to differentiate between the “profits and losses arising from the everyday operation of a business” on the one hand… and “the realization of appreciation in value accrued over a substantial period of time” on the other…
Does it make sense? I think it does. I know people who make money by buying broken cars, fixing them, and selling at a much higher price. Must be a reason why we call these people car dealers, right? I also know people who appropriately call themselves automobile investors: they buy rare cars, keep them for years and sell when the market allows for a profitable resale. Isn’t it real similar to real estate flippers vs. real estate investors?
Looking both at my auto business analogy and at the words of the Supreme Court, we can see some clues:
- a lot of regular work (as in everyday operation) indicates a dealer
- holding for a “substantial period of time” indicates an investor
- alternating short-term profits and losses indicates a dealer
- gradually increasing profit (“appreciation in value”) indicates an investor
- extensive effort and large operating expenses indicate a dealer
- ongoing advertising and active marketing indicate a dealer
- having other sources of everyday income (yes, I mean a job) indicates an investor
- a lot of fixing and improvements indicates a dealer
- careful maintenance and preservation indicates an investor
So, which question is the deciding one? Unfortunately, none – and this is precisely the problem. We’re supposed to weigh both sets of factors and decide which one prevails. Does it sound subjective, or even arbitrary, to you? You bet! Do you think you and the IRS can have opposing interpretations? Better believe it!
Couple bubbles to burst
Before we move on, I want to point out the two issues that are NOT included in the decision process. Not according to the IRS, not to the Supreme Court, and not to the common sense.
First one is that written declaration of intent. Yes, a well-written document consistent with the facts will very likely help your case. We Americans trust in paper. However, if the document contradicts the facts, we Texans take the facts over the paper. So will the IRS and the courts.
The second much-abused factor is how many. Did you see a single mention of the number of sales? Who said “less than three” or “less than five”? Where? The car dealer who sells two cars a year is still a dealer. Maybe a lousy dealer, but a dealer anyway. Likewise, a successful auto investor may sell 10 vehicles in one year, without losing his investor status. As long as he signs the guru-approved document, of course. Sorry, just kidding about the document.
Well, if this dealer-investor distinction is so unclear, how can you decide? Trust your guts. If you have your story straight and willing to take risks – go ahead and claim to not be a dealer. Let’s just clarify what it means to be willing to take risks. It means that
- you might be challenged by the IRS
- you might lose that fight, and
- you might have to pay them (and also pay professionals to help you with the fighting).
I have seen too many brave and macho investors who were so eager to stick it to the IRS – but only until the IRS wrote them a letter. It was the IRS version of statement of intent, as in:
We intend to crush you, Mr. Not-Dealer.
Can you avoid the dealer status?
Maybe. Accountants and lawyers who specialize in real estate came up with various advanced strategies to deal with the dealer threat. There is one critical point to remember: these strategies can help some investors in some situations. Get a competent advisor on your team, and be suspicious of anything that sounds too easy to be true.
Nothing (except maybe a guru-style statement of intent) can magically and instantly turn a dealer into an investor. Putting on a Batman cape will not help you fly. I tried when I was younger.
What to do if you are a dealer?
Cry.
Seriously, I’ll give you 5 reasons not to.
- Dealers can deduct all expenses related to their business: driving, education, computers, cell phone, home office. They can even write off the new truck, often all at once. The same deductions for investors, on the other hand, may be limited or even disallowed.
- Dealers can contribute to retirement accounts, including IRAs, SEPs, and 401(k) – sheltering their profits from taxes and building long-term wealth. Investors usually cannot, unless they have jobs or other non-investor income.
- Dealers can set up tax-advantaged benefits, such as deducting their health insurance premiums and other medical costs. Investors cannot.
- If a dealer business, after all possible write-offs, shows an overall tax loss – this loss can offset other family income, like job salary or pension. Investors, however, are sometimes limited in their ability to claim business losses.
- Finally, a large tax bill usually means that you made a lot of money as a dealer. Taxes are your cost of success. Would you rather pay no tax but make no money?
You may be thinking right now: what I really want is to make a lot of money AND pay zero taxes. Me too! I suggest you check with the gurus. I’m sure they can sell you binders full of helpful statements of intent, like this one:
My intention is to make a lot of tax-free income.
Your IRS auditor will be very impressed.